Sunday, November 6, 2016

Is Donald Trump's Crazy Tax Plan Just What the Doctor Ordered?

This post is inspired by a piece by Kevin Drum about low inflation. The problem is one most people never expected to have. Our inflation rate is too low, and the Fed seems powerless to raise it.

And no, that is not as crazy as it sounds. Yes, we really do need a certain amount of inflation so that next time our economy falls into recession we will not have outright deflation, and so that the Fed will have room to lower interests rates, if necessary, to below the inflation rate. Recall that the Great Depression began after a period of growth with negative inflation. Arguably that was one of the factors that made it so severe -- with inflation rates negative even in good times, there was buffer to prevent the economy from falling into double-digit deflation.

I suspect we're learning something new: central banks can squash inflation by raising interest rates and causing a recession, but no central bank has ever tried to raise inflation. It's simply been assumed that they have the power to affect inflation in both directions. But they don't—at least, not in practice. . . . Pretty much every central bank in the developed world would like inflation to be higher, but not a single one has been successful at doing it. This suggests to me that in practical terms, inflation is a one-way ratchet. Central banks can reduce it, but they can't raise it.

Cleaning up after the world's worst inflation

(Emphasis in original). On the one hand, this is ridiculous. Of course central banks can raise inflation, to effectively unlimited heights. Look at Weimar. Look at Zimbabwe. Even those do not set the real record. That dubious distinction belongs to Hungary, which experienced inflation of 41.9 quadrillion percent in one month! So obviously central banks can raise inflation rates. And you don't even have to look at such extreme examples. Just consider the double digit inflation of the 1970's as central banks first tried to boost the economy heading into an election and later overcompensated for a supply shock from increased oil prices.

But it may be more difficult to raise inflation when the economy hits the zero lower bound (i.e., central banks lower interest rates to zero and still can't bring the economy to full employment), or during secular stagnation. Here Drum offers some useful insights into what central banks are up against. Paul Krugman has suggested that all they have to do is promise to keep cranking out more money until inflation hits a suitable target. But how do central banks crank out money. The answer is by buying up government debt, i.e., by replacing government bonds with cash. Just how much will it take?

[I]t seems likely the Fed would have to increase its balance sheet by, say, 8x, to have any chance of producing substantially higher inflation. In dollars, that means $28 trillion in additional asset purchases. They would run out of treasuries to buy long before they hit that mark and would start gobbling up every corporate and MBS bond in sight. That's really not a tenable suggestion.

For what it is worth, US GDP for 2015 has been estimated that US GDP in 2015 was just under $18 trillion. If this rough estimate is correct, then printing money in an amount exceeding the total size of the U.S. economy would raise inflation by only a few percentage points! To produce serious inflation what is needed is not just printing money, but an attempt to push the economy past capacity. That normally takes the form of immense budget deficits. I was not able to find suitable information in a brief Google search, but I do recall seeing estimates of Weimar deficits. In the most fiscally responsible month, tax revenues covered about 28% of total spending. In the final and most disastrous month, tax revenues covered about one-tenth of a percent of the total budget. Clearly central banks can't raise inflation rates unless government cooperate by running large deficits to give them plenty of treasuries to buy.

Apparently last year's total budget was $3.8 trillion. Of this, about $3.18 trillion was raised by taxes and $583 billion from borrowing. That just isn't enough to get the inflation meter going. But have no fears. Donald Trump is proposing a trillion dollar tax cut, together with major infrastructure upgrades, a big military buildup, and no cuts to Social Security or Medicare. Now that should give the Fed the chance to buy up more treasuries and raise inflation.